Preparing Your Business for Sale Part 2: Minimizing Risk for Buyers

TL;DR

Selling a business is a multifaceted process that demands careful consideration of various factors.

• Balancing transparency and confidentiality is key, as is the discerning sharing of information during the due diligence process.
• Non-compete agreements can preserve the business's value post-sale and reduce competition risks.
• Providing post-sale training can facilitate a smooth transition, but it may necessitate a considerable time commitment from the seller.
• Seller financing can widen the potential buyer pool and possibly fetch a better sale price, but it carries the risk of non-payment and delayed full payment.
• Addressing and disclosing any negative issues upfront can build trust and prevent deal-breakers, but it may risk lowering the business's valuation.

Ultimately, selling a business requires a tailored approach and professional guidance to protect trade secrets, find the right buyer, and achieve a fair sale price, all with a focus on minimizing the buyer's risks.

Remember, success rates for business sales, particularly SMBs/SMEs, are low, with only 20%-30% of listed businesses resulting in a closed transaction. Proper preparation and flexibility are indispensable to enhancing your chances of a successful sale.

Welcome to the second installment of the Preparing Your Business for Sale series!

Business owners often possess several traits that can prevent successful and lucrative business sales, but the Top 3 traits that cause adverse impacts are:

1. They have not prepared the business for maximum sale value.
2. They have unrealistic expectations regarding value, as they calculate emotions and time spent in the business as value drivers.
3. They are unwilling to invest in the time and resources needed or have the flexibility on purchase terms to achieve a maximum sale price for their business.

We've created this series to assist business owners with Problem #1: Preparing the Business for Sale... NOW. Unlike traditional advice, we do not advocate waiting until 3-5 years from a planned exit, as unplanned exits happen all the time, whether due to health reasons, market dynamics, or unsolicited acquisition offers.

The Importance of Seller's Discretionary Earnings

Recognize the importance of achieving Seller's Discretionary Earnings (SDE) exceeding $100,000.

Seller's Discretionary Earnings (SDE) is a critical financial metric that investors and buyers consider during the business sale process. Achieving an SDE exceeding $100,000 is often seen as a benchmark of a healthy, profitable venture that can provide a sustainable income for the potential buyer.?

• Understanding SDE: The SDE is the pre-tax earning of a business before considering non-cash expenses, owner benefits, one-time investments, or any costs not integral to the daily operation of the business.?
• Why the $100,000 Threshold: An SDE exceeding $100,000 is typically viewed as an indication of financial stability and profitability. It signals to the buyer that the business is yielding considerable profits above its operating costs, making it a viable and financially secure investment.?
• Impact on Business Valuation: A higher SDE can significantly enhance the business's valuation. Most business value estimation methods involve multipliers against the SDE so that a higher SDE can result in a higher sale price.?
• Showing Profitability to Buyers: A strong SDE is a convincing argument for buyers who might be apprehensive about the business's profitability. It acts as an assurance that the business has the potential to generate healthy profits.

Achieving an SDE exceeding $100,000 is often seen as a benchmark of a healthy, profitable venture that can provide a sustainable income for the potential buyer.

However, there are also considerations to be aware of when optimizing for a higher SDE:

• Cost-Cutting Measures: While it might be tempting to increase SDE by reducing expenses, indiscriminate cost-cutting can lead to declining business quality or customer satisfaction, harming the business long term.
• Non-Recurring Expenses: One-time expenses or investments should not be considered in calculating SDE as they can distort the profitability picture of the business. Including them might decrease the SDE unnecessarily, impacting the perceived profitability of the business.

Strategically managing the financials to maintain a healthy SDE of over?$100,000?can make the business more attractive to potential buyers. While it's important to present a profitable picture, it's equally crucial to ensure that any measures taken to increase SDE do not compromise the business's quality or long-term sustainability.

Comprehend the advantages of maintaining consistent and dependable SDE.

Maintaining consistent and dependable Seller's Discretionary Earnings (SDE) can signal stability and resilience, two key factors that potential buyers look for in a business. Here are some strategies, considerations, and potential pitfalls to bear in mind:

• Stability and Predictability:?A stable SDE indicates a reliable income, fostering confidence in buyers about the business's future profitability. Buyers may be wary of erratic earnings, which can signify instability or a dependence on factors beyond the business's control.
• Business Sustainability:?Consistent SDE can also suggest a sustainable business model. It implies that the business is independent of temporary trends or irregular income boosts, which can reassure buyers about the long-term viability of the business.
• Financial Discipline:?Regular and dependable SDE demonstrates sound financial management and discipline, appealing to buyers who prefer a well-managed business.

However, there are certain aspects to be cautious about while maintaining dependable SDE:

• Risk of Complacency:?Consistency shouldn't lead to complacency. Businesses need to evolve and adapt to stay competitive continuously. Avoid resting on the laurels of a steady SDE at the expense of innovation or expansion.
• Unforeseen Challenges:?While consistent earnings are desirable, they are not guaranteed against future challenges. Unexpected costs, market changes, or emerging competitors can impact profitability, so contingency planning is crucial.
• Overemphasis on SDE:?While SDE is important, it's not the only factor buyers consider. Other elements like market position, customer base, growth potential, and intangible assets like brand reputation also play a significant role in the sale process.

A steady and reliable SDE can enhance a business's attractiveness to potential buyers, but a holistic approach that considers other important aspects of the business is essential for a successful sale.

Nondisclosure Agreements and Due Diligence Process

During the due diligence, potential buyers will require detailed access to crucial business information, making nondisclosure agreements (NDAs) necessary for both sides. This stage is intended to ensure that the buyer is fully aware of all aspects of the business, including financials, operations, legal considerations, and more:

Financial Due Diligence

Financial due diligence is the most critical aspect of the business sale process, providing potential buyers with a transparent view of the business's financial health and overall viability. This scrutiny extends beyond basic financial statements to encompass a variety of elements that can significantly impact the valuation and ultimate sale price of the business:

• Profitability Analysis:?An examination of the business's income statements can reveal profitability trends over time. A consistent record of profitability can reassure buyers about the business's stability and potential for future returns.
• Revenue Consistency:?Stable and predictable revenue streams can greatly enhance business value. Buyers will likely examine the variability and sustainability of revenues, as well as the diversity of the customer base.
• Cost Structure:?A detailed review of the business's cost structure can help buyers understand major cost drivers and potential areas for efficiency gains or reductions.?
• Cash Flow Analysis:?Cash flow is a vital indicator of business health. Businesses with strong, positive cash flows are likely more attractive to buyers.?
• Debt and Liabilities:?A comprehensive assessment of a business's debt profile can help potential buyers understand the level of financial risk associated with the business. High debt levels could indicate financial distress and may impact the business valuation.?
• Asset Evaluation:?Tangible and intangible assets can significantly boost a business's worth. An asset evaluation can reveal hidden value in intellectual property, real estate, or equipment.

Through diligent and extensive financial due diligence, buyers can gain valuable insights into the business's financial performance, which can guide them in their investment decisions and negotiation strategy. However, the process requires careful management to protect sensitive financial information and proprietary financial strategies.

Operational Due Diligence

Operational due diligence involves a careful examination of the functional aspects of the business. Here, the emphasis is on how the business operates daily and how these operations contribute to its profitability and sustainability. Key areas of focus include:

• Processes and Procedures:?Reviewing the business's standard operating procedures can offer insights into the efficiency and effectiveness of its operations. This can also highlight any potential bottlenecks or areas for improvement.
• Supply Chain:?Analyzing the supply chain provides a clear picture of the business's relationships with its suppliers and the impact of these relationships on the business's operations. It can also highlight any potential risks associated with supplier relationships.
• Staff and Management:?Assessing the competency and commitment of the staff and management team is crucial. This can inform the new owner about the skill level and dedication of the workforce they are inheriting.
• Assets and Inventory:?Inspecting the condition and value of physical assets and inventory can reveal important information about the business's financial health.?
• Market Position:?Understanding the company's position in the market, its competitive landscape, and its customer base can offer insights into the business's stability and growth potential.

While operational due diligence can provide invaluable insights, it has potential downsides. The process can be time-consuming and may expose sensitive information about the business's operations. Additionally, it may create uncertainty among staff if they become aware of the sale, potentially affecting morale and productivity. Despite these challenges, the insights gained through operational due diligence are essential for prospective buyers to decide about the acquisition.

Legal Due Diligence

Legal due diligence is a critical stage where potential buyers will investigate the legal status and standing of your business, including issues related to:

• Compliance:?The buyer will closely examine your compliance with all the relevant laws and regulations. This can range from environmental regulations to employment laws. A business that is in good standing legally is more attractive to potential buyers.
• Contracts and Agreements:?This involves scrutinizing all business contracts, partnerships, and agreements. Having all contracts and documents well-organized and up-to-date can speed up the legal, due diligence process and give buyers confidence in your business's operations.?
• Intellectual Property:?If your business owns any patents, trademarks, copyrights, or trade secrets, these will be thoroughly evaluated too. Ensuring your intellectual property rights are protected can increase the value of your business and make it more attractive to potential buyers.
• Litigation:?Any current or potential legal disputes your business is involved in will be evaluated. It is important to disclose any litigation issues up-front to build trust with potential buyers.

Pros:

• Legal due diligence allows the buyer to fully understand the legal standing of the business, making the transaction more transparent.
• It can expedite the sale process if all legal documents are organized and up-to-date.

Cons:

• It can be a time-consuming and costly process.
• Any legal issues found during this process can pose a significant risk to the sale of the business.?

Human Resources Due Diligence

Potential buyers will want to review the human resources aspect of the business. This involves looking at various factors such as:

• Employee Contracts and Agreements:?The buyer will want to evaluate the terms of employment contracts, any existing collective bargaining agreements, stock options, and other related documents.
• Employee Benefits and Liabilities:?This includes reviewing employee benefits, pension plans, and potential liabilities such as unpaid wages or bonuses.
• Employee Retention:?The buyer will want to understand the employee retention and turnover rates. High employee turnover can be a red flag for potential buyers as it may indicate deeper issues within the business.

Pros:

• A thorough HR due diligence process can reassure buyers about the quality and stability of your team.
• It can help identify potential HR issues that can be addressed before the sale.

Cons:

• If any significant HR issues are discovered, their negative impact on the business could reduce perceived value.
• The process may disrupt normal business operations if handled appropriately.?

In this phase of the sale process, it's about revealing just enough to maintain the buyer's trust and interest but not so much that you risk exposing sensitive company information. Finding this balance is a challenging but critical part of preparing your business for sale.

Using NDAs during the due diligence process helps protect the seller's confidential and proprietary information, assuring them to disclose necessary information to the potential buyer. However, implementing NDAs should be carefully managed to avoid unnecessary restrictions that could impede the due diligence process. Balancing the need for transparency with the need to protect important business information is crucial at this stage.

Understand the Role of Non-Compete Agreements

Non-compete agreements (NCAs) can help preserve the value of your business after the sale and reduce potential competition. However, their enforceability can vary by jurisdiction, and they may restrict your future business opportunities. So, it's crucial to understand the legal aspects and negotiation implications of an NCA before agreeing to it.

?A comprehensive analysis of NCAs involves:

• Definition and Scope:?NCAs need to carefully outline the prohibited activities and geographical boundaries to which they apply. The clause must be reasonable and proportionate in its restrictions to be enforceable.
• Duration:?The timeframe during which the NCA applies should be determined. While it should be long enough to protect the business's interests, excessively long durations might be deemed unreasonable in court.
• Enforceability:?The enforceability of an NCA depends on the jurisdiction. It's crucial to understand the local legal landscape and tailor the agreement accordingly to ensure its enforceability.
• Negotiation:?NCAs are often a point of negotiation in the sale process. A seller might want looser restrictions, while a buyer typically wants more stringent terms. Finding a balance that protects the business but doesn't unduly restrict the seller is vital.

The strategic use of NCAs can have significant benefits. They can protect a business's proprietary information, reduce competition, and help retain valuable staff. However, they also have potential downsides. If they're too restrictive, they can deter potential buyers and might lead to legal disputes. Additionally, they can limit the seller's future business activities.

Make a Plan for Post-Sale Training

Providing post-sale training to the new owner or management team can ensure a smooth transition and help maintain relationships with customers, suppliers, and employees. However, remember that this could be time-consuming and lead to potential conflicts due to differences in management style.

The process of structuring post-sale training should be methodical and efficient to ensure a seamless transition of the business to the new owner.?

• Identify Key Areas:?Start by identifying the key operational areas that the new owner must understand. These include customer service protocols, supplier relationships, product knowledge, and software systems.
• Develop a Training Plan:?Once the key areas have been identified, create a detailed training plan. This should include a timeline, learning objectives, and training methods.
• Timeline:?A realistic timeline that provides sufficient time for the new owner to become familiar with all aspects of the business is crucial. The timeline should be flexible to adjust to the learning pace of the new owner.
• Learning Objectives:?Clearly defined learning objectives provide a roadmap for the training and help both parties understand the knowledge and skills the new owner should acquire.
• Training Methods:?Consider the most effective training methods for each area. These could range from hands-on training to webinars to written manuals. Varying the training methods can help cater to different learning styles and keep the training engaging.
• Assign a Mentor:?Having a dedicated person from the existing team to guide the new owner through the transition can be beneficial. This person would provide direct assistance and answer any questions that arise throughout the process.
• Involve the Team:?Engage the existing team in the training process. Their expertise and business knowledge can provide invaluable insights to the new owner.

Pros:

• A well-structured post-sale training can ensure a smooth transition and reduce the risk of operational disruptions.
• It can help maintain key business relationships and keep employee morale high.

Cons:

• It can be time-consuming and may require a significant commitment from the seller even after the sale of the business.
• Any disagreements during the training process may lead to conflicts and potentially damage the relationship between the seller and the new owner.?

This process can be a challenging aspect of the sale of a business. However, the right approach and commitment can greatly contribute to the success of the transition.

Consider Seller Financing

Offering seller financing can make your business more attractive to buyers as it reduces their upfront capital requirement. However, this approach comes with the risk of non-payment and delayed receipt of the full sale price.

Seller financing is an effective strategy that can benefit both the seller and the buyer. Here, the seller acts like a bank, providing a loan to the buyer to cover part of the purchase price. The buyer then repays this loan over time, usually with interest.

• Interest Income:?One of the significant benefits of seller financing is the potential for additional income from interest payments. This can boost the overall return on the sale of the business.
• Attract More Buyers:?Seller financing can make a business more appealing to potential buyers. Reducing the upfront capital requirement broadens the pool of potential buyers who may not have been able to afford the full purchase price outright.
• Negotiation Lever:?Seller financing can be a powerful negotiating tool in the sale process. The seller can command a higher selling price or more favorable terms in exchange for offering financing.

However, seller financing is not without its risks and downsides:

• Delayed Payment:?With seller financing, the seller still needs to receive the full sales price upfront. This could be a disadvantage, particularly if the seller needs the funds immediately for other purposes.
• Risk of Default:?There's always a risk that the buyer may default on the loan payments. This can lead to complications, including potential legal disputes and financial loss.
• Encumbered Capital:?The seller's capital is tied up in the business until the loan is paid off. This may limit the seller's ability to invest in other opportunities.

While some owners may choose to retain their businesses and continue operations, others may view seller-financed payments over time as no more risky than ongoing business operations and decide to sell. For these individuals, seller financing offers an enticing alternative to keeping a business or accepting a significantly reduced sale price. By exploring this option, sellers can extract greater overall value as the economy progresses.

In weighing these pros and cons, a seller should consider their financial situation, risk tolerance, and the strength of the buyer's creditworthiness. These considerations will help determine if seller financing is the right strategy for their unique circumstances.

While some owners may choose to retain their businesses and continue operations, others may view seller-financed payments over time as no more risky than ongoing business operations and decide to sell.

Strategic Approaches to Seller Financing

There are several strategic approaches that a seller could consider when offering seller financing:

• Balloon Payments:?The seller might structure the loan to include balloon payments. This means the buyer will make small, regular payments for a period, followed by a large final payment to repay the remainder of the loan.
• Interest-Only Payments:?The seller could structure the loan to require only interest payments for a certain period. This reduces the buyer's initial payment burden but ensures the seller some regular income.
• Subordinated Debt:?In this scenario, the seller takes a secondary position to another lender. This allows the buyer to secure additional financing, but it increases the seller's risk as they will be the last to be paid in case of default.

Such strategies can make seller financing more attractive and manageable for both parties. However, each comes with its own set of challenges and risks. Therefore, it's crucial to seek professional advice before choosing a specific approach.

Remember, offering seller financing is a significant decision that can have long-term financial consequences. Therefore, it's essential to approach it with a solid understanding of the potential benefits, risks, and strategic options.

Disclose Negative Issues Upfront

Transparency about your business's challenges can build trust between you and potential buyers. However, disclosing negative aspects might lower your business's valuation and narrow the pool of interested parties. You must consider these factors and manage any legal implications carefully.

Disclosing the negative aspects of your business upfront is a double-edged sword. While it bolsters credibility and trustworthiness, it can influence potential buyers' perceptions and potentially devalue your business.?

Weighing the Pros and Cons Before Disclosing Negative Aspects

Before divulging any potential pitfalls, it's vital to weigh the pros and cons carefully:

Pros:

• Trust and Credibility:?By disclosing negative issues upfront, you demonstrate transparency, which can engender trust and credibility with potential buyers. This openness may foster stronger, more honest business relationships.
• Avoid Future Disputes:?Disclosing potential issues early on can prevent disputes in the future. If negative aspects surface after the sale, legal repercussions may ensue.

Cons:

• Lower Valuation:?Revealing negative aspects could lead to a lower business valuation as potential buyers may perceive higher risks associated with the purchase.
• Limited Buyer Pool:?Some buyers might need more clarity on disclosed issues, narrowing the pool of potential buyers.

Strategic Thoughts on Disclosing Negative Aspects?

When deciding whether or not to disclose negative issues, consider the following strategic thoughts:

• The severity of the Issues:?Minor issues that won't significantly impact the business might not need to be disclosed upfront. However, major issues, especially those that could result in legal or financial consequences, should be revealed.
• Buyer's Due Diligence:?Remember that serious buyers will perform due diligence. Hidden issues may surface during this process, so it's better to be upfront about them.
• Legal and Ethical Obligations:?Consider your legal and ethical obligations. Nondisclosure of major negative issues could lead to legal problems down the road.

Framework for Deciding What to Disclose

Consider using the following framework when deciding what to disclose to potential buyers:

1. Identify Potential Issues:?Identify all potential issues, including financial, operational, legal, and reputational.
2. Assess Severity:?Evaluate the severity of each issue and its potential impact on the business.
3. Consult Legal Counsel:?Engage a lawyer to understand your legal obligations regarding disclosure.
4. Determine Disclosure Strategy:?Decide on a strategy for disclosure, considering severity, buyer reactions, and legal implications.

Remember that every business has its strengths and weaknesses. Disclosing negative issues does not necessarily mean devaluing your business but presenting an honest picture of what the buyer can expect. This realistic approach can be a strong foundation for the new owner's success.

In Summary

Preparing to sell a business involves careful consideration of these aspects and more. Every business is unique, and a tailored approach is key to protecting trade secrets, finding the right buyer, and achieving a fair sale price. However, remember that only 20%-30% of businesses put up for sale result in a closed transaction. So, your preparation and flexibility will be paramount to your success.

Stay tuned for Part 3, where we discuss?Improving Accounting Procedures to drive an increase in value .

While this guide gives a glimpse into preparing your business for sale, there's much more to consider.?Discover our comprehensive guide on the 48 activities you need to start preparing your business for sale today ?rather than waiting 3-5 years before you plan to sell. This comprehensive guide will give you the insights to maximize the sale of your business, where 80% -90% of an entrepreneur's wealth is often tied up.

You can also discover why we advocate having your business ready to sale NOW.